How to Reduce the Risks of P2P Lending

There are a number of risks to be taken into account when investing in P2P platforms. In this article we are going to discuss each risk involved and how you can best mitigate said risks. This will allow us to get the best returns with the lowest chance of default.

Main risks that can be mitigated if understood:

Platform Risk

This is the risk of the platform its self. E.g. Ratesetter, Truepillars or Wisr. Each one of these businesses runs the risk of going bankrupt. So, in essence when you invest in one of these platforms loans you are somewhat investing in the platform itself.

This risk can be reduced by researching the platforms and understanding their stability by looking at factors such as their length in business, previous performance, management, etc. and making sure you only invest in those that are stable and trustworthy.

The other important thing to do is to invest across platforms, I personally do this as another form of diversification in addition to investing in various loans to reduce borrower risk. While we are not as lucky as the UK or US in regards to the number of platforms available to retail investors, there is definitely room to diversify!

Borrower Risk (Default Risk)

This is also known as credit risk and refers to the risk of a default (where the borrower fails to pay back the loan). The first and most obvious thing to do here to reduce risk is to invest across multiple borrowers. This reduces the amount of capital that would be lost in the case of a default similar to how investing across multiple platforms reduces the amount of capital that would be lost if a platform went bankrupt. For example, with my investments with Truepillars I invest up to $100 but aim for $50 where possible across over 30 loans.

The other thing you can do if the platform allows it is to make sure you research your borrowers. For example, while Ratesetter does not let you choose your borrower, P2P platforms like Truepillars do, they provide comprehensive information on each business so you can pick for yourself which ones you would like to lend to.

Cash Drag

This refers to the risk of a reduction in ROI (return on investment) as a result of funds sitting idle in a holding or similar account. The PDS of most of these platforms made it clear you will receive no interest for any funds are in a holding account. For this reason, it is important to mitigate this risk by monitoring your investments and having multiple platforms and borrowers you can move that money to ASAP to avoid the effects of cash drag.

Other risks to be aware of:

Policy Risk

There is always the chance of governmental rule implementation or changes that can affect an investment. However, since P2P lending is so new here in the world and specifically Australia, there is a higher risk that rules may be implemented or changed that could adversely affect your investment.

Market Risk

This is the risk that comes from the fluctuations and movements of the entire financial market such as interest rates. While you cannot avoid this risk, you can reduce the risk that comes with a portfolio that is only diversified within one type of investment. E.g. P2P Lending.

Network Risk

As P2P lending is an almost completely online business, there lives a high risk of attacks from hackers for your information, money and more. This is often referred to ask network risk. I believe the only way to mitigate this is to invest with established platforms you trust. These are much more likely to have strong measures in place to avoid such attacks.

Liquidity

This is not so much a risk to your capital but rather just an important consideration. However, if you were to need to access your money early, assuming the platform allowed it, you would likely incur heavy fees as well as a loss of interest.

While there are many advantages to P2P Lending, liquidity is not one of them. It is important to note this and one should always have an emergency fund (I like to have 6 months worth of living expenses saved up), separate to any money used to invest. This is particularly true when investing in P2P Platforms.

Summary:
-Research any platform you are considering investing in
-Invest across multiple platforms
-Invest across multiple borrowers
-Research your borrowers (If applicable)
-Monitor your investments to avoid cash drag
-Understand the lack of liquidity
-Understand the other risks that come with P2P Lending

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Compare Australian P2P platforms here:
https://www.aussiemoneyman.com.au/home/p2p-lending-platforms-compared-australia